People work hard when they’re young so that they can retire and live a comfortable life when they’re old (true for a majority, at least); a portion of the money earned is put away in a pension fund or other financial instruments. There are different types of pension funds, some depending on employment, some provided by federal or state laws and numerous plans provided by private industry.
One of the basic truths about your pension is that over time, the value of money accumulated erodes because of inflation and other factors. How then does one ensure that, at the time of retirement, the accumulated pensions are sufficient enough to continue living a comfortable life and still have enough left over to fulfill all those wants you’ve been deferring all your life as ‘things to do after retirement’?
Let’s start off with looking at the different types of pension plans that are available and then understand how you can derive the maximum advantage from your pensions.
Types of pensions
- Defined benefit plan: employer provides an agreed amount of money as benefit at the culmination of service. The benefit is calculated at a flat rate or on average terms of service or a percentage of earnings over a pre-determined period of time.
- Defined contribution plan: Contributions are made both by employee and employer; a separate account or fund is established where the contributions are deposited and the money is invested in a variety of instruments. There are several types of defined contribution plans, such as profit-sharing, money-purchase, stock bonus, 401(k) and ESOP plans.
- 401(k) plans: As an employee, you can choose to defer a portion of your salary before tax, with the employer providing a matching contribution, and the combined money is invested in a prescribed or predetermined financial instrument. The employee can choose between receiving a lump sum amount of cash at retirement, or as benefits paid out on an annual basis from the time of retirement until death.
- Individual Retirement Agreement (IRA): This is a personal savings plan that is open to anyone who earns taxable income, which can be in the form of salary, bonus, allowances, wages, commissions, alimony and/or maintenance payments. An IRA can be maintained by any person, irrespective of their age, and there is no minimum amount required to be deposited into the IRA. Money earned in an IRA is free from tax until withdrawal.
- Roth IRA: This is a version of the IRA with separate provisions on taxation on withdrawal, based on the Taxpayer Relief Act of 1997.
Making the most of your pension
Now that you have some idea about the types of pension plans which are available to you, the next question to consider is how do you use your pensions to get the maximum advantage, keeping in mind taxes, withdrawal limits, cost of living and inflation? Here are some possible questions and answers (not meant to be taken as qualified advice, seek a professional opinion for further clarity)…
- Calculate how much regular income you need post-retirement to meet your living needs.
- How much Social Security benefits will you be eligible for at various ages after retirement? Based on this, you can tweak the amount of regular income required as mentioned in the previous point.
- Should you take a lump sum amount at retirement or should you opt for yearly annuity payments?
- What are the big-ticket items for which you need to make provisions – healthcare, emergencies, buying a house or other large-value assets, travelling and/or entertainment expenses, etc?
- Those are some of the questions you may have on using your pension funds upon retirement. Now, for some suggestions that answer these queries…
- Lump sum amount or yearly annuity payments for life…
- If you’re looking for a safe and guaranteed source of income, opt for the annuity payments,
- If you’re investment-savvy, take the lump sum amount and use it to invest in a variety of investments such as stocks, bonds, multiple annuities, etc.
- A third option is to move all your retirement benefits (including those of your spouse) into an IRA.
- Decide beforehand at what age you will start drawing on Social Security benefits; the later the age, the more benefits you will accrue in money terms. This will impact the amount of pension funds you will want to use to meet your living expenses.
- Place a percentage of your accumulated pension funds in stocks and bonds and the remainder in annuities. Start with at least half of your pension funds in stocks and bonds and the rest in annuities. As you grow older, reduce the percentage invested in stocks and bonds and increase the amount invested in annuities.
- With respect to annuities, place your pension funds in multiple annuities from different insurance companies and at different points of time. This will help you in taking advantage of fluctuating interest rates.
These are some ideas about how you can make the most of your pensions. Research all the options and avenues which are open to you, and seek professional advice to live a comfortable and worry-free life after retirement.